- We are revising up our 2024 average US headline inflation forecast by 30bps to 3.3%.
- We expect a shallow rate cut cycle, short of a major demand shock in the coming 18 months.
- Various measures of inflation converging toward 2.5% would be sufficient for the Fed to ease.
- Two rate cuts in 2024 are on the cards, in early 3Q and 4Q.
- As growth and inflation slow in 2025, an additional 100bps of rate cuts will follow, in our view.
Commentary: If 2% inflation remains elusive
First things first; considering trade war, tech war, conflicts in Ukraine and the middle-east that threaten supply chains, and the hottest weather in record (month after month, lately), inflation has eased impressively since the middle of 2022. Of course, current headlines are oblivious of that, focusing on the stalling of inflation momentum on the downside. Indeed, the last few inflation prints have not helped the Fed’s desired narrative of a steady path toward the 2% inflation target. On the headline reading, energy prices have gone up this year, with nationwide gasoline prices up 11%ytd. At the core inflation end, insurance costs, recreation, and rentals are weighing in largely.
We see the markets, belatedly but rightly, realising that short of a major negative shock, it will be hard for Fed to justify substantial rate cuts in this cycle. Additionally, the first rate cut in this cycle won’t happen before 2H24, something we have been flagging since June of last year. Of course, as it is prone to do, market pricing has swung mightily in the other direction, with expectations now hovering around barely two cuts this year and less than three cuts next. A shallow rate cycle is the best one can expect, given the strength in demand and lack of a clear pathway to 2% inflation anytime soon.
Why is there still clamour for rate cuts? We think that that stems from notions of fiscal and financial dominance. There is this implicit view that given the large deficit-debt dynamic at the public sector level, and likely balance sheet risk of the financial sector from a prolonged period of relatively high nominal and real interest rates, there is only so long before something destabilising happens.
This notion has proven to be incorrect so far. US households and corporations have come across with modest duration risks, having locked into the historically low rates on their debt during the pandemic years. Rising yields have not caused bond market volatility to go up, with substantial private sector demand for US treasuries. Other than a few regional banks, the financial sector has also displayed considerable capacity to absorb the high rates, commercial real estate market stress notwithstanding.
The going has been fine so far, but that is no guarantee for more of the same. Surely Fed officials would not want to sacrifice the cycle by ignoring the disinflation so far and fixating only on the remaining work to be done. We think evidence of inflation settling around 2.5% will be good enough for the Fed to begin cutting. Furthermore, we believe the prudent risk management strategy for the central bank would be to cut modestly and gradually, as opposed to by a lot in a short period of time to deal with a recession when it is already too late.
We estimate that in the 2020-25 period, core PCE will have risen by a cumulative 15%, which translates into an annualised rate of nearly 2.5%. Would such an outcome through a once-in-a-century pandemic and myriad other shocks and disruptive fiscal/structural trends be considered a failure on the part of the central bank? We don’t think so. In fact, we think the Fed would look back at the first half of the 2020s with some satisfaction that the inflation spurt of 2021/22 was indeed transitory, and while the journey back to around 2% inflation was bumpy, it took place with no dent on the central bank’s credibility, as underscored by well-anchored inflation expectations. Consumer sentiment was hurt greatly when prices jumped, but as inflation eased, it improved long before the 2% goal was achieved. Rising energy prices may be grabbing headlines presently, the fact of the matter is the US household is considerably wealthier today than two decades ago, when pump prices were about the same, in real terms. From an affordability perspective, with wages growing at a faster pace than prices, the recent stickiness of inflation won’t cause the economic train to derail, in our view.
Does the 2% inflation target make sense amid deglobalisation, climate change, aging, and anti-immigration sentiments? This question will not get settled any time soon, but central bankers are surely not oblivious to these forces at play. Their communication may remain centred around how to bring back price stability, but a noisy global landscape does not give them the luxury of a narrow focus.
We think that 100bps of rate cuts in 2H24 are still on the cards, but no longer in the centre of the probability distribution. With growth and inflation both running above trend, it will become increasingly hard for the Fed to cut month after month. A signal that policy has room for normalisation would likely be provided with a 25bps rate in July, in our view, but the next cut will have to wait till 4Q.
After 50bps of cuts in 2024, we think the Fed will continue with quarterly cuts next year, taking the policy rate down to 4% by the end of 2025. Stretching the definition of “higher for longer,” communication would be provided that the terminal rate of the cycle, along with the so-called nominal neutral rate or r* is at least 3%, if not higher.
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